Understand the relationship between interest rates and inflation

Understand the relationship between interest rates and inflation

Interest rate and inflation

On September 19th and 20th, the US Federal Reserve (the Fed) should meet to talk about US monetary policy and hold a press conference to share its decisions and economic projections.

After more than 7 years with ultra-low levels, the EDF has raised 2 times this year in March and June. Investors are wondering if it will be able to respect its rates increase schedule, namely 3 increases in 2017.

Inflation and interest rates are linked macroeconomic concepts. Interest rates are generally guided by central banks based on their statutes. Price stability (inflation) is generally an objective of most central banks for the purpose of ensuring a quality of life to their populations (constant purchasing power).
Relationship between inflation and interest rates

In general, the lower the interest rates and the more economic agents in need of financing (individuals and businesses) are able to borrow money because it is cheaper.

Thus, these agents have more money to spend on their personal or professional projects, which increases consumption spending and investment, generally leading to increased growth and inflation.

With stronger interest rates, consumers tend to save more to benefit from larger remuneration and their available income is therefore lower. With less expenses, the economy tends to slow down and inflation to decline.
The role of a central bank

A central bank is the supreme monetary entity that seeks to influence economic conditions through its monetary policy. There are many tools that a central bank can use to vary the cost and availability of money in an economy: Minimum reserve ratio, Open-Market operations, exchange rates and certainly one of the More important: interest rates.

By modulating interest rates the central bank of a country vary the money mass, that is to say the amount of currency available in the economy and easily convertible, which plays on the general price level, So on inflation. According to INSEE, "inflation is the loss of the purchasing power of the currency that results in a general and sustainable price increase". It is usually measured by the CPI or consumer price index. It is an index that "estimates, between two given periods, the average price variation of household products".

A change in the direct interest rates will be reflected in other interest rates billed by banks for loans (student loans, automotive loans, commercial loans ...), which will affect the money spent by individuals and companies. Consumption and investment habits will be modified, which also changes price level.
Importance of inflation and interest rates on currencies

As we have said the central banks have the task of controlling the monetary mass and maintaining the economic stability of the countries represented. Monetary policy decisions of these central banks directly influence currencies by fluctuating the cost and availability of money in an economy by lower or higher interest rates.

Thus, if the central banks inflation objective is respected, then interest rates will increase what will tend to attract foreign investors. The demand for this currency will therefore be stronger what will reinforce this currency compared to other currencies.

Investor's expectations for a country's future monetary policy is also strongly moving currencies. Forex market traders are constantly an eye on the particular economic timetable when there are central banks meetings during which important decisions can be made.

However, every speech of the members of a central bank is analyzed to detect information on possible future actions. Central banks want to avoid increased panic and volatility in the markets then they must communicate clearly and accurately on their actions and schedule. We would not want to relive a new tsunami from the Swiss franc that occurred when the Swiss National Bank abandoned its course Floor facing the euro ...